For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

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All investing is subject to risk, including the possible loss of the money you invest.

Any long-term investor knows that inflation is the enemy. A spike in inflation can drastically reduce your real investment returns, particularly for fixed income securities. At present, yields on many Treasury Inflation-Protected Securities (TIPS) are negative, a clear reflection of “financial repression.”

Officially, the Consumer Price Index, or CPI, has risen approximately 2% over the past 12 months, a rate of inflation that is near historical averages. Many economists—including those at the Federal Reserve—believe that, with unemployment high, we needn’t worry ourselves with the prospect of a significant rise in inflation in the years ahead.

However, as I blogged about in January, inflation is a non-issue only for those who don’t buy gas or milk, visit the doctor, or send a kid to college (in other words, not many of us). Drought in much of the country will put pressure on food prices going forward. When I look around, inflation seems to be everywhere except in the CPI.

But even if you think inflation is modest today, you may share the concern that inflation could take off in the next two to three years and face the high, double-digit inflation rates of the 1970s and early 1980s. Some believe that it’s not only a strong possibility—but that it’s also inevitable given the Federal Reserve Board’s aggressive monetary policy and our high national debt levels. Could such action to keep interest rates low and the money supply high in the near-term future create an inflationary backlash? If so, what would be the “canaries in the coal mine” that investors could monitor to tell them a repeat of the 1970s was coming?

The three bars to the left in the figure above are the “canaries” because they represent the mechanisms by which money on the Federal Reserve’s balance sheet can be transmitted onto the broader money supply. Things such as bank lending and wage growth—the factors that help determine the “velocity” of money. The chart clearly shows that the conditions in the 1970s were radically different from today’s environment. Money was burning a hole in Americans’ pockets in the 1970s; today, the velocity of money is low.

The bars represent two-year trailing average growth rates for each category. The blue bars combine the averages from 1972 to 1973 and from 1977 to 1978, and they indicate that inflationary pressures were building in the economy two years before inflation spikes. Two years before the gas lines, America had a big inflation problem. Businesses had pricing power because consumers could afford it. Pricing power meant that, when gas prices spiked in 1974 and again in 1979, businesses were able to pass on those costs, further accelerating inflation. It was a classic case of too much money (in the form of wages and lending) chasing too few goods.

Current fashion trends aside, the 1970s are hardly how I would characterize the environment today. Wages, lending, and home prices are all expanding modestly: 2% wage growth, 2% inflation. Which explains, not only the suffering associated with higher food and energy prices, but also the Fed’s aggressive posture. The Fed’s moves are designed to re-inflate a tire that the financial crisis drove a nail into. Somewhat remarkably, the Fed has been able to keep the green bars in the chart in positive territory—and avoid wage deflation. (Japan was unable to avoid that, it should be noted.)

Which brings us to QE3, the third round of so-called quantitative easing, under which the central bank will attempt to encourage borrowing by consumers and institutions by purchasing $40 billion worth of mortgage-backed securities for an unspecified period.

So, will QE3 work? If by “work” we mean driving inflation expectations above 2% and lowering already-slim mortgage rates even further, then likely “yes.” But if “work” is defined by a significant and sustained acceleration in job growth, then that is unlikely, especially if QE3 is unmatched over the next year by sensible, credible, and binding U.S. fiscal deficit reform. As Chairman Ben Bernanke noted, monetary policy is not a “panacea” to all of the economy’s challenges.

Personally, I am not a big fan of QE3, which we could call “QEternity” given its somewhat open-ended commitment to preserve the odds of further recovery. Why? As I blogged about in March, I am concerned about the potential for too strong of an influence on the decisions facing savers and investors. As Vanguard has noted for some time, we have already seen that, by reaching for yield, investors are taking on more risk and boosting asset prices. Should such trends continue, I worry about the “frothiness” of certain segments of the financial markets. The prices of high-yielding REITs and junk bonds come to mind.

So why is the Fed pursuing QE3 at all? I believe it is concerned about the near-term global economic outlook. The global economic recovery has clearly lost some momentum, partly due to uncertainty over how the fiscal cliff-hanger will be resolved. Should a global recession occur, the threat of deflation would rear its ugly head once again.

My biggest concern right now is not the threat of runaway inflation. Rather, I am concerned about market complacency. With the broad U.S. stock market up strongly over the past year, the financial markets are increasingly “pricing in” a vigorous U.S. economy in 2013—perhaps 3% real GDP growth or so. I hope the stock market is right in its assessment, although risks remain tilted on the downside.

While our long-held view for the U.S. economy has been one of cautious optimism, I find myself increasingly stressing the “cautious side” when discussing the financial markets with investors. Not because the U.S. economy isn’t resilient (it is). Rather, it’s because the markets never move upward in a straight line. No matter how much we all wish that they would. And no matter how large a central bank’s balance sheet becomes.

I would like to thank Casey Aspin and Charles J. Thomas for helpful comments and assistance in developing this blog post.

Notes: All investments, including a portfolio’s current and future holdings, are subject to risk, including the loss of principal. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

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Joe Davis

Joe is Vanguard's global chief economist and head of Vanguard Investment Strategy Group. He's also a member of the senior portfolio management team in Vanguard Fixed Income Group. Joe's global research team is responsible for overseeing Vanguard's investment methodologies and asset allocation strategies for both institutional and individual investors. They also provide thought leadership on a broad range of investment topics, including the capital markets, the global economy, and portfolio construction. In 2004, Joe was selected as a faculty research fellow at the National Bureau of Economic Research for his contributions to the fields of economic history and U.S. business cycles. Before joining Vanguard, Joe spent time as an economist at Moody’s Analytics. Joe earned his M.A. and Ph.D. in economics at Duke University.

Comments

Richard G. | September 3, 2016 2:17 pm

To Mr. Davis: I really appreciate your article although I am really not sure what a tie-die is.I am an overall newbie to Vanguard. It seems to me if you do what Vanguard tells you to do then you are always going to have a handle on this “inflation” problem.Some one mentioned an ” age appropriate” investment program.I was told that you are not to invest in the market with any money that you are going to need in the short term (5 years) or under.Buy the whole market(I use index funds).Keep a cash cushion( I use two years salary). Before retirement get debt free.Each year or so when you rebalance what has gone up you sell and whatever has gone down you buy.Mr. Bogle seems to think this fact alone will make you money.If you set up your portfolio like the above then it is going to be “crater free”. I only invest using facts not based on someones guess.Each year when I bring up my account with Vanguard I see exactly what my buy the whole market 10 index funds have done.If six have gone up I sell those and I buy what has gone down and return back to my chosen asset mix.I have found that you really do not have to be a rocket scientist to follow Vanguards advice.It does become a little boring watching my portfolio grow every year but such is life and someone has got to do it.I started saving at 18 and thanks to exercising a little forethought Vanguard has allowed my wife and I to retire 8 years early and we are very comfortable financially.Good Luck to All with your programs.

Anonymous | January 19, 2013 11:45 am

I travelled Latin America from 1970-1988. I saw what happened to the people when their governments wasted money and tried economic idiocies like the Fed is trying today. Inflation is here: I see that you agree with that. The banks are flush with cash and have been reflated in a sneakier way than in the 1980’s. At that time ‘savers’ at least had a chance. During the last four years their money has been stolen with safe interest rates one percent or less and prices rising. It seems that the government wants everyone to spend, another idiotic policy. Recent history has shown that economists who claim “inflation is dead” have been dead wrong. What I don’t understand is the apparent lack of complaint from “savers” when keeping money under the mattress earns just as much as an interest-bearing checking or savings account.

Anonymous | November 29, 2012 8:23 pm

Joe – You and your team put out some really good research briefs that I truely find helpful. One challenge Econmists have (I am an Engineer so I too am “challenged”) is that they are either data centric (Vanguards style), or philosophers. What they don’t do well is look at current trends and predict the future. From my perspective, I agree with what your data is telling you, but I look outside the data and not only do I personally feel alot more inflation, but I see labor feeling more empowered to protest and push for more (even with low unemployment). It seems what is not in the numbers is that the labor market is actually tight for employees who are skilled or frankly even willing to work. I also see the government getting more involved in health care as adding demand which will only make that big sector of the economy even more burdened. Add to that demographics of more old folks needing health care and you have a big problem in a 1/4 of the economy. Thus, the numbers may be cold comfort for a rough patch of inflation that is likely here but we, like the parabol of the boiling frogs, aren’t seeing it in the numbers. Thanks again for all the study papers. Vanguard investors are a smart bunch that like solid information to make there own decisions about how to invest their money.

Anonymous | November 15, 2012 7:37 pm

In this era of de-leveraging, it’s deflation and not inflation that is of concern. We are in a secular bear market and drawing to the end of a cyclical bull move precipitated by quantitative easing and not due to organic growth in company earnings. … The Shiller PE is above 20 and so stock prices are vulnerable to a recession brought on by the “fiscal cliff” and widespread increases in taxes of all kinds. The Fed has done its best to increase the rate of inflation, and investment in risk assets, but with little results. Even the casual observer can see that Keynesianism does not work.

Anonymous | November 15, 2012 1:29 pm

Anonymous | November 13, 2012 12:19 am

No body can predict what inflation is going to look like. The best thing every investor can do is to be prepared and have balanced portfolio that also takes care of inflation risk. If someone talks like an expert and tries to predict, take it with a pinch of salt

Anonymous | November 10, 2012 4:36 am

Inflation : I agree with previous comments, but is inflation really the problem ? Are we not still in a strong de-leveraging cycle fed by too much debt, stagnant wages, stringent lending criteria, poor fixed income returns coupled with high short term borrowing costs and demographics. By the latter I mean the millions of babyboomers retiring who will surely be downsizing in housing and budget (except medical). Is not the damper on inflation in the private sector the lack of demand?

I recently retired and am very sensitive to an asset rich, cash poor scenario for the next decade or two, particularly as the overall US political sentiment moves towards more social engineering, etc…..

Anonymous | November 13, 2012 11:20 am

Ditto! asset-rich, cash poor. Well, not exactly asset RICH, more like asset moderate, but I second your point wholeheartedly. There’s a long cycle here, I fear, and we are not near the end of it.
Of course, we could always have stagflation, why not? It happened in the 70s and can happen again.

Anonymous | November 2, 2012 3:52 pm

First-year macroeconomics: there is a trade-off between inflation and unemployment. Unemployment has been high on a long-term measurement for over 10 years, and I think that’s been keeping inflation low. But if unemployment is to ever go back down again, I would expect inflation to rise accordingly (possibly alongside a bull market). Of course with the increase in structural unemployment and poor prospects for young college graduates in non-technical positions, this may not actually happen for quite some time.

Anonymous | November 2, 2012 3:36 pm

I am curious about your view on how we should allocate the fixed income portion of our portfolio. The fact that interest rates are intended to remain low until 2015 doesn’t leave much room for future growth in bond prices as they are low when compared to past history. I believe that people should have more shorter duration securities of roughly about 3 years to maturity. This will limit the downside risk of longer term securities due to the inevitable reversion to the norm that will happen sometime in the future yet still allow them exposure to the fixed income market. What are your viewpoints on this?

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For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.